ECB Backdoor Bailout

The details of how the ECB means to relax collateral have not yet been released. The Bank currently accepts collateral rated as low as A-, although debtors must pay a penalty based on asset risk. Were even riskier sovereign bonds allowed to be used as collateral or if the penalty were dropped, this would provide significant incentive for banks to purchase sovereign debt, particularly given currently high yields on bonds. That would hike demand for sovereign debt in countries that have currently seen high borrowing costs, bringing down yields on sovereign bonds, and thus making it easier for PIIGS sovereigns to finance their debt.

So, you can already take risky Sovereign debt to the ECB. The problem is that it is marked-to-market, which means the price in the secondary determines how much cash you can get for your bonds.

I think all my readers know that bond prices and yields move in opposite directions, but lets think about what that means for collateral.

Suppose I am a bank and I an buy Italian bond at 1.5% yield from the Italian government. After all, I can borrow at 1% from the ECB so this is just free yield.

Then I take it to the ECB and get my money. Then the bond yields on the secondary market climb to 6%. I then have to add more bonds as collateral to the ECB. How much more. Until the total market value of my bonds equals the amount of cash that I borrowed.

Yet, that amount is precisely the amount that takes the yield on my cash borrowing up to 6%. Because, yield is determined by price which in turn determines collateral value.

So, I get no easy arbitrage. Now, I can buy lots of Italian bonds at 6% take them to the ECB exchange for cash and then continue about my merry way. And, if there are no defaults I get a 5% spread. However, this is simply what it means to be a financier. You take on risk in exchange for spread.

Essentially, this new policy is really a test of confidence. If banks believe that countries like Italy and Spain can continue to pass austerity measures and that EU leaders will continue to move towards fiscal consolidation that will make the euro area more stable in the future, then they will buy PIIGS sovereign debt buy the bushel, as there is no limit to the ECB’s funding policy. If not, then they won’t buy enough and the crisis will continue to intensify.

As above this was always true.

What’s now potentially true is that banks will be flush with liquidity. This relieves strain on money markets and the struggle to find high quality collateral back repo transactions.

That in turn lowers systemic risk in the financial sector which in turn both boosts reduces the probability of a shock that would lead to default and enables banks to hold more Sovereign credit risk, which itself lowers the probability of default.

Now, at the same time there is the chance of really taking this bad boy to the bank and getting the whole spread. However, it would require a fair bit of hoop jumping and there are questions about exit risk.

The core idea would be to load up on Sovereign Debt and the knock the system towards the safe equilibrium. You can do this a number of ways but if you are big enough the easiest is just to offer to finance the full rollover of Sovereign debt. Then default goes out the window, bond yields collapse and you take all the chips on the table.

The question is what happens when three years are up? However, its not clear to me whether that is an issue. I have to think about it more, but it would seem that if the Sovereign cannot pushed towards the safe equilibrium by this then I question how banks under its jurisdiction and holding its debt where going to make it anyway.

Sometimes an all out move risks nothing, because if you can’t win by throwing in everything that you have then you couldn’t win under any condition. It then depends on what “losing” looks like. If there is some way to lose and survive then you may still want to be cautious. If there is not, then you go all in.

Collateral eligibility is not the only new measure froth ebb. full allotment of term money is as well a game change. in full allotment the only limit to banks funding from ebb is collateral. in normal times this is not the case as there is a probability your bid rate is too low for the money you want to get at ebb auctions.
the other important point is about long term funding : banks are not neutral to their liability maturity as they have regulatory constraints to meet in terms of asset/liability matching.
so the game is not exactly the same as before even if you still have to get some cooperation between Italian banks to move the equilibrium